Regardless of what type of investment(s) you own, knowing how they will be taxed is important. That’s because it can have a significant impact on how much the investment grows, as well as how much you will eventually net out as actual, spendable income in the future.
Take, for instance, a tax-deferred annuity. With these financial vehicles, there is no tax due on the gain until the time of withdrawal. Because of that, your earnings can compound, as you can generate a return on your contribution, as well as on the previous growth, and on the money that otherwise would have been paid out in taxes.
How is Income from an Annuity Taxed?
Although the funds inside of an annuity aren’t taxable, once they are withdrawn, the amount of tax you owe will depend on how the annuity was set up – primarily, whether it is qualified or non-qualified.
For instance, a non-qualified annuity is one that is purchased with after-tax funds whereas a qualified annuity is one that is purchased with money that has not been taxed yet. As an example, if you use money from personal savings or checking account to contribute to an annuity, the funds will still grow tax-deferred, but when you make a withdrawal or receive an income payment, a portion of it will be considered taxable gain, and another portion of it will be considered a non-taxable return of your principal.
The percentage of your withdrawal that is not subject to taxes is referred to as the exclusion ratio. Anything above the exclusion ratio will be subject to taxes at your then-current ordinary income tax rate.
It is important to note that the exclusion ratio will expire when all of the principal in the annuity contract has been received by the annuitant (i.e. the income recipient.) From that point on, 100% of the remaining withdrawals will be taxable.
A qualified annuity is funded with pre-tax dollars. These funds may be rolled over from a traditional IRA account and/or an employer-sponsored retirement plan such as a 401(k). Because your contributions have not yet been taxed, these funds – as well as the tax-deferred gains – will all be subject to taxation upon withdrawal.
How Much Tax Will You Pay?
Although the tax-deferred nature of annuities can allow you to grow your account exponentially, at some point you will likely face taxation upon withdrawal. How much will this tax be?
The answer depends on what the income tax rates are at the time you make your withdrawals. Currently (in 2020,) the top federal income tax rate is 37%. But over the past century or so, this rate has fluctuated anywhere from a low of just 7% to a high of 94% in the mid-1940s.
Top Federal Income Tax Rates 1913 – 2020
Source: Inside Gov (http://federal-tax-rates.insidegov.com/)
So, how can you reduce – or even eliminate – taxation on an annuity?
One way is to own the annuity in a Roth IRA or retirement account. With a Roth account, the money that is contributed has already been taxed. The growth in the account takes place tax-free, as do the withdrawals – regardless of what the then-current income tax rates are.
Which Type of Annuity is Right for You?
The tax-deferred nature of annuities makes them an attractive method of continuing your tax-advantaged retirement savings, even if you have already maxed out your IRA and/or 401(k) plan contributions.
Before you purchase any type of annuity, though, it is recommended that you talk over your objectives, time frame, and risk tolerance with a retirement income specialist. At Annuity Gator, our focus is on educating consumers – and financial advisors – on how annuities work, and on narrowing down which annuity, if any, may be right for you.
If you would like to set up a time to talk with an annuity expert, feel free to reach out to us directly at (888) 440-2468, or send us an email by going to our secure online contact form. We look forward to hearing from you.